November 17, 2014
How Not to Innovate (and How to): IBM v. Facebook, Amazon
by Chunka Mui
Facebook and Amazon are investing for the long term. IBM? Not so much.
You don’t often see a CEO squash a great quarter with an analyst call script designed to batter his company’s stock price. Yet, that’s what Mark Zuckerberg recently did—to his great credit.
One of the biggest challenges for public companies is to make investors prioritize long-term value over short-term profits. So, rather than running a victory lap after beating Wall Street’s expectations for the third quarter, Zuckerberg laid out a long-term strategy that drove loads of investors away.
To understand why this was a smart move, look at Amazon.com and IBM.
Few CEOs have been more audacious than Amazon CEO Jeff Bezos in managing Wall Street. Bezos told investors 17 years ago, “It’s all about the long term. . . . Our goal is to move quickly to solidify and extend our current position while we begin to pursue the online commerce opportunities in other areas…. We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.”
Bezos has, ever since, eschewed profitability to invest in—and deliver—innovation and growth in ever-expanding retail categories and adjacent markets, including tablets, phones, original content and cloud services.
In return, Amazon attracted investors who believed in his long-term time horizon, as evidenced by Amazon’s astronomical price-to-earnings-ratio and a market cap that stands at nearly $140 billion. Amazon’s costs have risen to eat up all revenues — but the stock price has rocketed.
At some point, Bezos will have to deliver profits commensurate with Amazon’s scale, but, for now, investors continue to give him wide latitude to invest for the long term.
Contrast Bezos’ approach with that of his counterparts at IBM. In 2006, IBM CEO Sam Palmisano told investors that IBM would focus on earnings per share, ahead of growing IBM’s business. Palmisano’s rationale, as he recently told Harvard Business Review, was that IBM was a “mature business” that needed to respond to the demands of shareholders who “wanted more margin expansion and cash generation than top-line growth.” Palmisano dubbed his plan Roadmap 2010 and committed to increase earnings per share from $6 to $10 by 2010.In return, IBM amassed like-minded investors who drove up IBM’s share price in lockstep with earnings growth. Roadmap 2010 was so successful with investors that Palmisano and his successor, Ginni Rometty, doubled down on it with Roadmap 2015—which called for IBM to deliver $20 per share by 2015.
While investors loved them, Roadmaps 2010 and 2015 took IBM far off course in meeting the needs of its customers and employees. The problem is that while IBM might well be a mature company, it competes in an industry that was far from mature in 2006, and is even less mature today. Rather than accepting old age, IBM needs to be as agile as startups and growth-minded goliaths—like Amazon. But Palmisano and Rometty locked IBM into a set of investors and expectations that left less and less room for agility.
Rather than staying on top of the rapid advances in information technology products and services redefining its industry—and every one of its target markets—IBM management had to focus on financial and business reengineering to increase earnings for its investors, as promised.
One industry insider summed up IBM’s predicament this way: “They are paying the price for moving to services—which was smart—but not investing in the fundamentals to support services, e.g., recruiting, training, staffing, etc. They kept their earnings afloat by financial engineering, such as loading up on debt to fund buybacks.”
IBM paid a high price for not innovating. It suffered declining revenues for the last 10 quarters—to the point where Rometty had to abandon Roadmap 2015.
The superiority of Amazon’s long-term market leadership approach over IBM’s short-term profitability considerations is evident in the two giants’ battle over cloud services.
Who could have imagined in 1997 that one of the next big things in IT services would be cloud services, and that Amazon would be the dominant player in that space? If anyone should have foreseen and owned the cloud, it should have been IBM—given its deep client relationships and long history of running data and networking centers for corporate clients.
Yet, BusinessWeek estimates that Amazon Web Services is one of the fastest-growing software businesses in history:
The growth of Amazon’s cloud business is unprecedented, at least when compared to other business software ventures. It’s grown faster after hitting the $1 billion revenue mark than Microsoft, Oracle, and Salesforce.com. You would need to turn to Google—which had the advantage of the vast consumer market—to find a business that grew faster.
Amazon has also vanquished IBM in head-to-head competition, including for a high-profile 10-year, $600 million contract for cloud services to the CIA.
What’s more Amazon’s initial success has drawn other deep-pocketed competitors like Google and Microsoft. The resulting price war might have more dire consequences for IBM, which does not have Amazon’s long-term investment flexibility.
So, when Zuckerberg prepared for his recent earnings call, he could have easily crafted a story that short-term investors would have loved. Facebook beat expectations for both top-line revenue and bottom-line profits. It also made great strides in showing that it would dominate in the mobile space—a transition about which many observers (including me) had been skeptical. Facebook’s share price would surely go for a nice ride if Zuckerberg simply focused on monetizing his social network.
Instead, Zuckerberg took a page from Bezos’ playbook and laid out five and 10-year visions with aspirations far beyond the core Facebook network. He told investors that he would build a series of other billion-user products—before starting to monetize them. What’s more, he said that Facebook would build the next major computing platform, which he believes will revolve around augmented reality. And he made it clear that this vision required significant investment and that, like Bezos, he would prioritize long-term market leadership over short-term profitability: “We’re going to prepare for the future by investing aggressively.”
The subsequent drop in share price meant that a lot of investors got the message, and left.
Zuckerberg still needs to deliver on his long-term strategy. But he left little doubt about his intentions and made sure that his investors were working on the same assumptions. That’s smart.